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Malcolm Berko: A primer on preferreds

Preferred stocks offer corporate ownership along with unique characteristics that include qualities of a bond and a common stock.
Published: December 23, 2012

Dear Mr. Berko: We are the 81- and 83-year-old seniors (we travel and live together) who you advised to take the $28,000 cash value from two life insurance policies and invest it in dividend utility stocks. It took us nearly nine months to get our money, because the insurance man wanted us buy a variable annuity with the money. The broker we took the money to recommended a Preferred Stock Exchange Traded Fund paying 6 percent called PowerShares Financial Preferred. Please tell us what a preferred is and if this is OK instead of a utility, which does not pay 6 percent.

SG and DL,

Oklahoma City

Dear S&D: Preferreds are a class of corporation ownership with the unique characteristics of a bond and a common stock. Like bonds, preferred stocks are issued with a fixed par value and pay dividends (not interest) at a fixed rate, based upon that par value. For example: A preferred may be newly issued at $25 (par value) and pay a $1.50 dividend, which is 6 percent of par value and a 6 percent yield on the price. If the value of the preferred rises to $30, it still pays a $1.50 dividend, which is 6 percent of its $25 par but a yield of 5 percent on market price. And if that preferred falls to $20 it still pays a $1.50 dividend or 6 percent of its $25 par but a 7.5 percent yield on market price.

Unlike bonds, preferreds are not considered debt securities — they represent equity ownership of a corporation but don't have voting power. Like bonds, their prices are sensitive to changes in interest rates. And as interest rates rise, Preferred stocks, like bonds, which are fixed income investments, will decline in price. When interest rates fall, preferreds, like bonds, generally rise in price. Unlike bonds, preferreds usually have no maturity date, but like bonds they may be redeemed (called) by the issuing corporation on a specifically published date. The redemption price may be higher (never lower) than the $25 par value, but the redemption price may be lower than the market price.

Preferred stocks are senior to common stocks. This seniority allows preferred shareholders to stand ahead of common shareholders in the distribution of dividends and in the liquidation proceeds in cases of bankruptcy. So a preferred shareholder's claims are junior to bondholder's claims. And like convertible bonds, some preferreds are convertible into a specific number of common shares of the issuing company. This feature allows preferred shareholders to simultaneously lock in an attractive yield and participate in the potential appreciation of the common stock. It's almost like having the best of both worlds.

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